Q3 2018 Market Commentary

Posted on: 10/10/2018

If you believe that the trend is your friend, then perhaps the U.S. stock market is in for an excellent fourth quarter. U.S. equity markets suffered small losses in the first quarter, followed by decent single-digit gains in the second quarter. Now that the third quarter is in the books, a larger gain has put stocks in solid positive territory for the year.

What’s going on? The American economy roared in the second quarter of the year, but most economists believe that the 4.2% GDP growth number was inflated, both by short-term corporate earnings as a result of the tax cuts, and by a short-term effort by multinational companies to complete as much overseas business as possible—including via their manufacturing supply chains—before the widely-publicized tariffs took effect.

That suspicion seems to have been confirmed by a variety of new economic statistics. On the jobs front, initial claims for state unemployment benefits rose by 12,000 to a seasonally-adjusted level of 214,000—above expectations. On the manufacturing front, non-defense capital goods orders excluding aircraft, a proxy for business investment, fell 0.5% in the recent quarter. As a result, Morgan Stanley and Barclay’s economists lowered their growth estimates to 2.7% and 2.8% for the third quarter. This is solid but not spectacular growth, a bit above the 2.2% growth rate the U.S. economy has experienced, on average, since mid-2009. Altogether, we may be looking at a year of 3% growth.

But then you have the Federal Reserve Board’s recent (and widely anticipated) decision to nudge the Fed Funds rate up to a range of 2-2.25% in September and to raise short-term rates again in December. Higher short-term rates are not necessarily bad for the market, and it is certainly a good sign that Fed economists believe the U.S. market is strong enough not to need additional stimulus. But the Fed seems to be intent on continued raises next year, when the biggest impact of the corporate tax rate reduction will be behind us, and when we enter unknown global trade territory due to the imposition of tariffs on U.S. trade partners.

Another interesting question is how investors will be affected by the ballooning U.S. federal deficit. This year, the $21.5 trillion national debt quietly passed the size of the U.S. GDP. The Congressional Budget Office estimates that this debt level will more than triple in the next 30 years, and that by 2028, the debt-to-GDP ratio will be the largest it’s been since the end of World War II.

So what? As the U.S. government begins flooding the world with Treasury bonds, they are likely to become cheaper—which means their interest rates will be higher. Higher interest rates could be associated with lower stock market returns, due to the increased cost of borrowing. Also: consumer debt—credit cards, home mortgages and student loans—becomes more expensive, taking a bite out of disposable income. Disposable income is the fuel that drives GDP growth, in the form of consumer expenditures. These are all things to ponder, not things that will help you pinpoint the hour and the day when the bull market finally comes to an end. If we knew that time, chances are we would all be selling out before—causing it to happen before the appointed time. All we can do for now is wait and wonder.